Introduction to Macroeconomics

Macroeconomics is the branch of economics studying the behavior of the aggregate economy – at the regional, national or international level.

While microeconomics is concerned primarily with the decisions made by an individual within the usual economic constraints of scarcity, macroeconomics (Greek makro = ‘big) is the field of study that is concerned with the indicators that reflect the performance of the broader economy- gross domestic product, inflation levels, unemployment, growth rate, fiscal deficit etc.

If you are trying to gain a better appreciation of the macroeconomics problems of the Indian economy that get covered in newspapers and TV channels, this post should help you get the basic principles of macroeconomics.

What is macroeconomics?

The aim of studying macroeconomics is to understand how an economy works, and identifying the levers that can be pulled to put the overall economy on the right path of growth. The system that is a result of different economic agents coming into contact is much more complex than the sum of its independent and often disjoint parts.

Moreover, it is strictly “non-experimental” as we do not have the luxury of conducting controlled experiments like in the field of science. We can just wait and observe the effects of broader policy measures with a certain level of accuracy and a tinge of hope.

It usually deals with goals that are conflicting; ensuring growth, taming inflation, full employment and fair income distribution at the same time!

Introduction to Macroeconomics – Basic concepts

Currency

Before the advent of money and modern economic systems, barter was prevalent to facilitate the exchange of goods and services. Money has many advantages over the barter system and serves multiple functions: it is faster, convenient, holds value over time and both parties are not obligated to want what the other is offering ensuring freedom of choice through a neutral medium of exchange.

There is no scope for confusion as everyone knows the current value of one unit of a currency (atleast they think they know!). Interest rate is the cost of borrowing money, which in turn is dependent upon the current demand of money in the economy.

An exchange rate signifies the rate at which one currency will be exchanged for another. The two primary types of exchange rate systems are – fixed and floating. In fixed rate systems, the participating countries agree upon the relative value of their currencies and maintain the same rate by buying/selling their foreign reserves in the case of demand fluctuations for their currency.

Fixed exchange rate system was mostly prevalent in the 19th and 20th centuries, and currencies were backed by gold in the good old days (now it is not the case, read about fiat money). In floating exchange rate systems, the value of the currency is determined by the market forces, just like any other good.

Inflation

Simply put, inflation is the erosion in value of a currency, as its buying capacity diminishes over time. Alternatively, it can also be defined as a significant increase in the prices of goods/services in an economy for considerable time duration. Consumer Price Index (CPI) and Wholesale Price Index (WPI) are the measures of inflation used in India.

There is no broad consensus upon the right rate of inflation in the economy, but majority believe that a slightly positive rate of inflation signifies growth and is best for the economy.

• Wild variation in inflation is the major source of headache for economists and can lead to a variety of problems in the economy: the saving sentiment of the populace erodes due to uncertainty in the value of deposits and the long-term investments may dry up due to significant risk associated with final returns.

Business cycles

Business cycles are the patterns of expansions & contractions in the economy. During a phase of expansion, gross domestic product (GDP) rises and the unemployment rate falls. While recession has found its place in the pop culture and now usually means any downturn in the economy, the definition of recession usually requires the real GDP to decline for two consecutive quarters.

There is no set consensus among the economists as to what decides the extent of these cycles, and the role government should play in influencing these cycles. Lowering taxes and increasing spending usually provide the required stimulus to the economy during downturns. Some see this cycles as totally irregular phenomenon, while some believe that overall technological throughput of the economy drive these cycles.

Unemployment

• : Good rate of employment within an economy is important for a couple of reasons – unemployed workforce is pure wasted potential, plus it leads to lowering in consumer spending as they’ve got nothing to spend!

There are three sub-categories of unemployment:

• Cyclical unemployment: Result of business cycles, not harmful to the economy in general
• Frictional unemployment: Result of lags in information dissemination and imperfect matching of jobs and skilled workers
• Structural unemployment: Result of workers not being equipped for the jobs that are available, can be detrimental to the economy

While a very low rate of unemployment is desirable, absolute zero unemployment is neither desirable nor practically possible. The general relationship that exists between inflation and employment – higher the rate of employment, higher is the rate of inflation. Balancing it all does require some serious effort after all.

Economic growth

Gross Domestic Product: What is GDP?

GDP full-form: Gross domestic product. GDP is the total value of the final goods/services produced in an economy and is the most commonly employed measure of a country’s economic capacity. GDP in effect is a measure of ‘value added’, the value added is more if an entity produces more output with every unit of available input.

‘Real GDP’ measures economic output after adjusting for price changes, i.e. inflation or deflation. The ultimate goal of any economic growth is to translate into a higher standard of living, and measuring GDP per capita is an approximate way to do that. A sweet side effect: it serves as a barometer to gauge the success (or lack thereof) of major economic policy changes.

There are some drawbacks to the use of GDP though: –

• The GDP calculations exclude any form of unpaid/illegal activity. In a country like India where a significant portion of economy is “underground”, the real GDP can be grossly underestimated.
• It fails to take into account the losses that happen due to natural or man-made disasters, but the rebuilding activity after a war or a natural disaster will cause the GDP figures to shoot up.
• It also fails to capture the improvements in quality of life due to increased affordability of goods over time;also ignores transactions where no money comes into picture (think of NGOs) and does not take into account the value of all assets in the economy.
• The sustainability factor also does not come into picture as the high GDP can be a result of over-utilizing the nation’s natural resources.
• Last but not the least, it does not take into account the distribution of wealth (a few wealthy individuals can hold a very significant amount of money in an economy). It is generally measured through Gini coefficient. For instance, “Gini” tells that the income distribution is fairly skewed (screwed?) in South Africa whereas Scandinavian countries are egalitarian havens.

A gap exists between the potential GDP that an economy could generate through optimum utilization of labor and capital, and the actual GDP that is generated which is called the output gap.

International Trade

Liberalization, Privatization and Globalization are the factors which have been responsible for the spurt in economic activity in India for the past two decades. Without international trade, the world suddenly becomes a very large and disconnected place.

The consumers have to compromise on the available choices (getting a landline connection before 90’s was a luxury in India and a thriving black market for regular commodities was the norm). Specialization is the backbone of all modern economic activity, and a nation can maximize its welfare (and that of the world) by making goods which it produces most efficiently—competitive advantage.

Balance of payment tracks the financial flow, the components being the flow of goods/services and/or the investments. To make the payments exactly balanced with a trading nation, the earnings from selling goods/services and the return on investments should be equal to the spending on goods/services and the outgoing investment income.

While we are increasingly moving towards free international trade, the governments can introduce barriers to trading which can come in various forms such as tariffs or quotas, primarily to save local industries from foreign competition as a temporary measure or to impose sanctions on a trading partner.

Tariffs cause the imported goods/services to be artificially expensive as compared to the domestically produced goods. Similarly subsidies can be provided to the local manufacturers which artificially make local goods/services cheaper as compared to the foreign counterparts.

Macroeconomic policy

The macroeconomic policy of a nation is implemented with two levers: fiscal and monetary.

• The money supply in the economy can be altered through several means by the central bank. The usual action is to increase the money supply by offering bonds which lowers interest rates, or selling bonds to take some money out of circulation. Inflation is another beast that has to be tamed while ensuring a steady and high growth rate in the economy.

When the interest rates are already near zero, the conventional approaches do not work. Quantitative easing is an unconventional technique which was adopted by the US Federal Reserve to stimulate the economy which was in doldrums due to the worldwide financial crisis. In QE the government purchases assets from private institutions, commercial banks etc.,instead of the usual government bonds.

• Fiscal policy involves governments’ lawful tinkering of balance sheets, i.e. decisions related to changes in revenue and expenditure to take hold of the overall economy. Let us take the case of a nation which is currently in a state of recession. If the tax rates are lowered, people have more disposable income which will fuel the economic activity. Another way is to increase spending, say by initiating an infrastructure project. This will create jobs, lowers the unemployment rate and boosts consumer spending which will be a positive stimulus for the overall economy.

Generally, monetary intervention is preferred over fiscal as the average lag in the case of implementing monetary policies is far lesser than fiscal; a central bank is involved for implementing monetary policies which is usually a strong non-political institution.

Macroeconomic schools of thought

• Classical economics is a school of thought that’s generally regarded as the first school of economic thought and is widely associated with Adam Smith, the father of modern economics. The central idea behind the ideology is that markets work best when they are left alone and role of the government be as minimal as possible. The ‘invisible hand’ in the free markets automatically assigns resources to places where they are best utilized.
• Neo-classical economics is hinged on the premise of rationality in behavior, and that the consumers are looking for maximum “utility” and the firms are looking for maximum profits. This fundamental conflict gives rise to the current demand and supply theory.
• Keynesian economics derives its roots from the ideas of the British economist John Maynard Keynes (widely regarded as the most important economist of the 20th century). It is a theory which relies on government intervention to manipulate aggregate demand through changes in fiscal policy.It also posits that free markets rarely move towards full-employment equilibrium.
• Monetarist economics is a school of thought largely attributed to the contributions of Milton Friedman. The central belief is: The role of the government is to control inflation through manipulating money supply. They believe that attempts to manage demand in an artificial way (the Keynesian way) can be destabilizing to the overall economy and can lead to inflation.
• Through tracking major macro-economic indicators, an investor can expect to make better investing decisions, a salaried individual can plan savings/investments in a better way and a businessmen can take more informed decisions about raw materials or labor.
• The knowledge of macroeconomics is an important tool in the arsenal of every individual, and the future might lie dormant in the government’s stance on a few key policies.